The recently released statistics for output in the first quarter of
the year appear to confirm the message from other indicators that the
economic recovery has finally got underway. In contrast to the
'false dawns' in the autumn of 1991 and spring of last year
there is now plenty of hard evidence with which to reinforce the
improvement in optimism apparent once more in business surveys. The
expansion so far this year is more widely based than in the early months
of last year, when an improvement in the manufacturing sector was offset
by continuing weakness elsewhere.

We continue to forecast that the economy will grow by 2 per cent this
year (a forecast unchanged since last November), with a small upward
revision in the forecasts for domestic demand offsetting a downward
revision to the prospects for exports as the recession in continental
Europe deepens relative to our previous expectations. The recovery is
likely to gain momentum in the second half of the year as the full
effects of the reductions in interest rates since last September begin
to emerge and as improved consumer and export demand is met directly by
additional production rather than from existing stock holdings.

The provisional figures for GDP in the first quarter of the year,
released earlier than usual, suggest that non-oil GDP rose by 0.6 per
cent after remaining flat throughout most of last year. The estimated
growth in total output was more subdued at 0.2 per cent, in line with
the small rises experienced in the second half of last year. Chart 1
compares the profile of output over the course of the present recession
to that in the mid-1970s and early-1980s recession. (In each case the
level of output in the quarter prior to the onset of the recession is
shown as 100.) Although the duration of the present recession was longer
than either of the other two, the fall in output was not as severe as in
the early-1980s. However, because of the length of the recession, output
is presently as far below its pre-recession level as it was in the
corresponding stage of the last recession.

The latest official figures for both output and the cyclical indicators suggest that the trough of the recession was reached in the
early months of last year. Even so, it is not surprising that in the
latter half of last year it was widely felt that the recession was
deepening, as the early stages of the recovery have been weak, with
unemployment and bankruptcies continuing to rise sharply. The strength
of the recovery in the early months of this year is directly
attributable to the policy changes that followed after the suspension of
ERM membership last September. Whilst the fall in sterling has had an
immediate impact on the tradeable goods sector, it is unlikely that the
full effects of the reductions in interest rates have yet emerged. A
simulation analysis of the effects of changes in interest rates on
domestic demand is shown in Box A below.

The latest round of business surveys confirm the improvement in
expectations apparent in surveys three months ago, with the balance of
firms in the CBI Industrial Trends Survey who are more optimistic about
future prospects rising to a level higher than at any time since April
1983. The improvement in confidence follows a tangible pick-up in new
orders, primarily due to higher export orders. The volume of exported
goods rose sharply in the fourth quarter of last year, with a further
rise of 4.4 per cent in exports outside the EC in the first quarter of
this. After stagnating in the second half of last year, manufacturing
output rose by over 1 1/4 per cent in both January and February.

Retail sales have recovered strongly after falling just before
Christmas last year, with growth of 1 1/2 per cent in the first quarter
of the year, well above distributors' expectations. There are also
signs that the housing market may be beginning to stabilise, with the
seasonally adjusted Halifax price index rising by 1.2 per cent in March
and 1.6 per cent in April, to leave prices some 2 1/4 per cent below the
levels of a year ago. However, the real user cost of housing investment
remains well above the levels at the height of the housing boom, even
though nominal mortgage rates are at their lowest level since the
mid-1970s. The stabilisation in prices would suggest that the imbalance between demand and supply has eased this year, helped by the reduction
in repossessions and the extent to which unsold properties have been
taken out of the market by housing associations following the measures
announced in the Autumn Statement.

The most surprising news in the first quarter of the year was the
successive monthly falls of 25,000 in claimant unemployment in February
and March, although the average level for the first quarter as a whole
was above that of the fourth quarter of last year. The drop in the
claimant count was widespread, with a small decline reported in all
regions. As yet the reasons for this decline are unclear. Unemployment
would normally be expected to continue rising for some time after output
begins to recover and our previous forecasts showed a peak of 3.17
million in the first quarter of next year. This was partly due to an
assumed rise in participation rates as the economy recovered, since
employment was forecast to stabilise from around the middle of this
year.

One possible explanation for the reduced inflow into unemployment
apparent in the early months of this year is that the participation
effect is smaller than we had previously anticipated. Figures from the
latest quarterly Labour Force Survey for the autumn of 1992 suggest that
the number of 'discouraged workers'--those who would like to
work but do not seek work as they believe few jobs are available--was
around 14 per cent higher than in the summer months.

It may also be the case that the monthly figures for employment in
manufacturing industry (released much earlier than those for
non-manufacturing employment) provide a weaker guide to employment
trends in the whole economy than previously thought. Recently released
results from the 1991 Census of Employment have led to the level of
manufacturing employment being revised down by over 100,000, with a
corresponding upwards revision to employment in services. This revision
reflects the extent to which the contracting out of ancillary service
activities by manufacturers has been greater than previously thought. In
the latest British Chambers of Commerce Survey the balance of firms in
the service sector expecting to raise employment was positive, whilst
manufacturing firms continued to indicate that their employment would
decline. A similar picture for manufacturing emerges from the CBI
Survey, although the balance of firms planning to reduce employment has
now fallen to the level reported in 1983, a time at which whole economy
employment was rising.

Although we have made little change to our forecast for employment
levels this year, we have adjusted our unemployment forecast to allow
for a lower participation effect than before. As a result, unemployment
remains broadly flat throughout the remainder of this year. Thereafter
we expect to see a gradual decline, with employment recovering, the
working population rising at a much slower rate than in the early-1980s
and the special employment measures announced in the Budget becoming
fully operational.

The Budget measures aim to reduce long-term unemployment by some
100,000, with an extra 30,000 places being offered on full-time
vocational courses and 60,000 additional places being created in the
Community Action programme. As these measures are concentrated on the
long-term unemployed who have relatively little influence on wage
settlements it is likely that the upward pressure they will place on
earnings will be a little lower than would be the case if the measures
had been targeted at the short-term unemployed. It is likely that the
overall impact on earnings of a change in total unemployment will be
limited in any event. Charts 2 and 3 which compare the rise in claimant
unemployment and the fall in the growth of average earnings over the
last three recessions suggest that the rise in unemployment has had a
much weaker impact on the growth of earnings in the present recession
(see also the note by Soteri and Westaway in this Review). To the extent
that this simply reflects the fact that the underlying growth of
earnings was lower at the start of the present recession than in 1980,
it implies that nominal rigidities in the UK economy are widespread,
with inflation proving extremely difficult, and expensive, to reduce
once it has fallen to a low level.

One factor behind the recent stickiness of inflation has been the
extent to which manufacturers have increased their markups over the
course of the recession. Producer output price inflation (excluding
food, drink and tobacco) has remained at 2 1/2 per cent since the early
months of last year, even though unit wage costs in manufacturing fell
by 2 per cent in the year to this February and input costs were falling
until the sterling devaluation. The continued rise in domestic producer
prices during 1992 at a time when producer prices have been stable, or
actually falling, in the United States, Japan and Germany has
undoubtedly been an important factor behind the continued rise in import
penetration over the course of the recession.

Three alternative measures of the real exchange rate are shown in
Chart 4, along with their forecast levels for this year. In all three
cases the real exchange rate at the time of the sterling devaluation was
considerably above the average levels prevailing throughout the
late-1960s and the 1970s. The continued upward movement in the price of
domestically produced manufactures relative to the price of imported
manufactures in 1992 suggests that many domestic firms selling to the
domestic market increased their margins last year, offsetting some of
the improvement in the underlying relative cost position. In contrast,
there has been little trend in relative export prices in the second half
of the 1980s, suggesting that increased competitive pressures within
world markets were being reflected in export prices, with prices held
down to retain market share. Average manufacturing export prices
remained unchanged throughout the period of ERM membership.

On all three measures the average real exchange rate this year is
likely to be some 10-15 per cent below the average for 1992. UK
exporters are now potentially more competitive than at any time in the
last decade. As we explain in the analysis of manufacturing exports in
Box C below, a change in competitiveness of this magnitude should allow
exporters to raise their market share. The early trade figures since the
devaluation suggest that the improvement in competitiveness is already
having a noticeable effect. For the year as a whole we presently expect
the volume of manufacturing exports to rise by over 8 per cent. The
improvement in export sales following a large change in competitiveness
can be substantial in an open trading environment, even allowing for the
weakness of many export markets.

Prospects for export sales also depend on the timescale over which
the improvement in competitiveness is maintained. As the chart shows,
the improvement in competitiveness following the 1967 devaluation proved
short-lived, even though an incomes policy was in operation at the time.
Although exporters have apparently shown a greater determination to
price to market in recent years, and it is unlikely that prices will be
raised substantially in continental European markets, the latest data
for non-EC trade suggest that the price of manufacturing exports to
these markets rose by 6 1/2 per cent in the first quarter. If prices
continue to adjust in this fashion, or if the exchange rate is allowed
to appreciate substantially, then the gains from the recent fall in the
real exchange rate could easily prove smaller than we presently expect.

Policy Assumptions

UK interest rates have remained unchanged at 6 per cent since January
despite recent falls in interest rates elsewhere in Europe. With the
differential between UK rates and rates elsewhere having become less
negative than previously expected by the financial markets, sterling has
appreciated a little from the low point reached in February this year.
We continue to base our projections for interest rates on the rates in
the forward markets, with the exchange-rate forecast using an uncovered
interest parity condition. Thus we show base rates remaining flat for
the remainder of this year before gradually rising next year as concerns
about inflation come to the fore. To some extent such concerns have
already begun to be reflected in forward rates, with the yield on 10
year government bonds having risen by 1/2 a percentage point since
mid-March. Further details are given in Table 10.

Considerable uncertainty still remains as to how judgments over the
appropriate stance of monetary policy are reached. Interest-rate changes
are officially made in the light of movements in a number of financial
indicators such as asset prices, the exchange rate and broad and narrow
monetary aggregates, in order to ensure that underlying inflation
remains within a target range of 1-4 per cent. The difficulties in
establishing the way in which policy judgments are arrived at within
this informal approach have been demonstrated since the beginning of the
year by the behaviour of the monetary aggregates. Growth in 'narrow
money', MO, has risen above the official target range of 0-4 per
cent while the growth in 'broad money' M4, has fallen below
the bottom of its official monitoring range. Uncertainty is compounded
by the decision to move the goalposts in the new Medium Term Financial
Strategy (MTFS), with the MO target range downgraded to a monitoring
range and the monitoring range for M4 widened to encompass its present
growth rate.

The overall Budget judgment for the present financial year was much
as we had expected, with little net change in taxation in addition to
the measures previously announced. Additional measures were taken to
help the housing market and the long-term unemployed and personal income
tax allowances were frozen for the year. Total tax revenue will be some
|pounds~2.3 billion higher this year than would otherwise be the case
with revenue also boosted by the previously enacted reduction in
National Insurance rebates for employees contracted out of the state
pension scheme and the abolition of stamp duty on securities dealing.

A number of important measures were also announced for April 1994
reflecting a desire to reassure the financial markets that action was
being taken with regard to the PSBR while limiting the extent to which
tax rises would constrain the nascent recovery this year. From April
1994, the rate of employees' National Insurance Contributions will
rise by 1 per cent (raising revenue equivalent to a 1 percentage point
increase in income tax), VAT will be extended to household fuel and gas
consumption and a number of tax allowances and reliefs will be
restricted to the lower tax rate of 20 per cent. In total the measures
are designed to raise an additional |pounds~6.7 billion in 1994/5 (1.0
per cent of GDP) and |pounds~10.3 billion in 1995/6. The pre
announcement of such changes can be expected to have some affect on
consumer behaviour, although it is unlikely that it will offset the
continuing feed through of the impact of the recent reductions in
interest rates.

Of more concern is the extent to which such changes will add to wage
pressures next year. The extension of the VAT base along with the
commitment to raise petrol duty by 3 per cent in real terms will add
over 1/2 per cent to the price level next year alone. The changes in
personal taxes are likely to add to the pay problems that can be
expected TABULAR DATA OMITTED to emerge as the present public sector pay
policy begins to unwind.

The out turn for the PSBR in 1992/3 was |pounds~36.5 billion (6 per
cent of GDP), some |pounds~1.3 billion below the level forecast in the
Autumn Statement last year. In spite of this and the upward revision in
the Treasury forecast for growth this year, the Budget forecast was for
borrowing of |pounds~50 billion this year (8 per cent of GDP), some
|pounds~5 billion above the Autumn Statement projection. The MTFS
projections show borrowing remaining above 3 per cent of GDP well into
the medium term, with the projected growth and inflation rates much
closer to those shown in our forecasts than had been the case in the
Autumn Statement (see the February 1993 Review).

We continue to show a lower level of borrowing than the Treasury,
with our forecast being for a deficit of |pounds~44.9 billion this year
and |pounds~41.1 billion in 1994/5. In part this reflects the higher
level of inflation in our forecasts which serves to raise nominal tax
receipts. An indication of the short-term uncertainty attached to these
forecasts is provided by the historical forecast errors reported in
Table 13 below, with the average error for the May forecast for the
present financial year PSBR being some |pounds~5 3/4 billion. In the
medium-term projections are inevitably far more hazardous. After all, it
was only five years ago when the possibility of paying off the National
Debt by the turn of the century was raised. On present trends, the ratio
of outstanding debt to GDP is instead set to double by that date.

Given the uncertainty surrounding the state of the public finances we
have made the technical assumption that the November Budget will not
contain any additional net changes in taxation to those already
announced. It is more likely that the Treasury will wish to take action
with regard to public expenditure. With the volume of government
procurement expenditure actually declining by 1/4 per cent last year, we
have revised down our forecast of future spending a little.

Summary of the forecast

The provisional estimates of activity in the first quarter of the
year are closely in line with those shown in our earlier forecasts and
thus we have again made little change to our forecast for growth this
year. Although our forecast incorporates the provisional figures for GDP
we would not be surprised if the growth shown was not eventually revised
up a little. If anything, the news with regard to domestic demand has
been slightly more encouraging than we had previously expected, possibly
reflecting the extent to which consumer spending and investment were
both stronger last year than previously thought. Thus we have revised up
our forecast for domestic demand growth this year by 1/4 per cent,
offsetting the impact on export sales of a downward revision of 1/2 per
cent in projected world trade growth. (An alternative set of projections
from our leading indicator models for growth and inflation are reported
in Box B below.)

We expect the recovery to gain momentum through the year, with the
continuing impact of the reductions in interest rates offsetting the
announcement of future tax increases. Growth next year is forecast at
around 2 3/4 per cent. If the recovery becomes as firmly based as we
presently expect, it is likely that interest rates will begin to rise
around the turn of the year, slightly sooner than we had previously
anticipated.

With consumer borrowing remaining depressed in the early months of
this year, the recent improvement in retail sales has been financed out
of disposable income and existing savings. The lower level of interest
rates along with greater stability in the housing market are expected to
induce further small falls in the savings ratio over the coming months
to 10.6 per cent by the year end. Consumers expenditure is forecast to
rise by 1 1/2 per cent this year and a little over 2 1/4 per cent next
year. The simulation results in Box A provide an indication of the lags
before changes in interest rates have their full effect on expenditure.

The fall in the total volume of investment last year is now put at
1/2 per cent, considerably smaller than we had once thought, with the
level of investment expenditure rising by over 1 per cent in the second
half of the year. With the volume of public sector investment forecast
to rise by 5 per cent this year and the real cost of capital forecast to
fall further in the coming months, we expect that the total volume of
investment may rise by some 2 1/2 per cent. Chart 5 indicates that the
real user cost of capital in manufacturing is presently lower than at
any time since the mid-1970s, reflecting a combination of lower real
interest rates, temporarily higher investment allowances and the recent
decline in the real (and in some cases nominal) cost of investment
goods.

The growth in domestic demand is likely to be accompanied by a
further substantial rise in import volume despite the improvement in the
competitive position of the UK. For the year as a whole we expect
imports of goods (on an overseas trade statistics basis) to rise by 6.3
per cent. In contrast we expect little change in the volume of imported
services, reflecting their greater price sensitivity in our econometric equations. With import prices forecast to be some 11 per cent higher
this year than last, the current account deficit is likely to widen further over the coming months despite a forecast improvement in export
volumes. For the year as a whole we expect a deficit of |pounds~20.6
billion (3 1/4 per cent of GDP), with only a small improvement in 1994.

The impact of the sterling devaluation is likely to ensure that the
recent reductions in the rate of inflation come to an end in the second
half of this year, with producer price inflation rising to around 3 1/2
per cent by the year end and underlying inflation rising outside the
official target range. In the short term inflation may remain more
subdued, with retail price inflation possibly declining a little in the
second quarter of the year, helped by lower mortgage rates and the
continuing evidence of retail price discounting as retailers attempt to
reduce stock levels. In contrast to our earlier assumptions it now
appears that the average level of the council tax will be little changed
from that of the community charge, largely due to widespread
charge-capping, although some of this will be offset by higher council
rental charges than would otherwise have been the case. For the year as
a whole retail price inflation may average around 2 per cent, rising to
2 3/4 per cent by the year end.

Thereafter some change in the seasonal profile of inflation can be
expected to emerge as a result of the move to a November Budget, with
all excise duty changes coming into effect on Budget day (with the
exception of changes in alcohol duties which come into effect from the
start of the calendar year). To some extent inflationary pressures have
been held down since last September by the combination of the public
sector pay constraints and the impact of lower interest rates on overall
retail prices. With both these factors exerting a weaker influence next
year and the indirect tax changes announced in the Budget adding a
further 1/2 per cent to prices next year, we expect the year on year
growth in retail prices to rise to around 4 1/2 per cent.

The medium-term projections associated with the present forecast are
shown in Table 12 below. These show the recovery beginning to slow in
the middle of the decade, with a tighter monetary policy and a
continuing balance of payments deficit acting to constrain demand. The
medium-term profile of claimant unemployment is close to that shown in
the base case in the analysis of employment prospects on page 5 of this
Review.

One issue of considerable interest in the medium term is the speed
with which the economy returns to a level of output at which the present
level of spare capacity is eliminated. In turn this depends on estimates
of the trend rate of utilisation of both capital and labour. One
possible method of estimating the extent to which the economy is
presently working below its trend level is to calculate the level of
output that would be produced at present if the economy had grown at its
long-run potential rate from a particular reference point. Such
calculations are sensitive both to the assumed growth rate and the
starting point. For example, if 1986, the year before the boom, is taken
as the reference point, then a potential growth rate of 2 per cent would
imply an 'output gap' of 3 1/4 per cent at the end of 1992. A
potential growth rate of 2 1/2 per cent would imply a gap of 6 per cent.

An alternative approach is to use direct evidence on utilisation.
Chart 6 shows capacity utilisation in the manufacturing and distributive sectors using our own calculated estimates of potential output (at full
capacity) in these sectors. Both series are defined relative to their
long-run average level (of 100). Whilst utilisation in both sectors at
present is a long way below the peaks reached at the height of the boom
in 1988, it is not too far below the long-run trend and capacity
utilisation in manufacturing has recently begun to pick up. Based on
estimated values for the first quarter of this year, utilisation in
manufacturing is some 3-4 per cent below trend, while utilisation in
distribution is around 5-6 per cent below trend. The size of these
estimates reflects the extent to which potential output has failed to
rise over the course of the recession, with investment merely replacing
existing capacity rather than expanding capacity.

Thus while domestic firms may face little immediate difficulty in
expanding output to meet higher demand, bottlenecks and other production
difficulties could soon start to emerge if investment does not recover
sufficiently so as to raise potential output and help sustain the
recovery. The forecast paths for utilisation shown in Chart 6 suggest
that utilisation in distribution will have returned to its long-run
trend by 1997, while that in manufacturing may have overshot a little by
that date. The relatively short timescale over which this adjustment
takes place suggests that an absence of further measures to stimulate
industrial investment could prove an important impediment to a
long-lasting economic recovery.

Section II. The Forecast in Detail

Personal Sector

The level of consumers' expenditure began to pick up from the
first quarter of last year. In the fourth quarter consumption was some
1.3 per cent higher than a year earlier. Year-on-year, consumption rose
by only 0.2 per cent despite a rise of 2 1/4 per cent in real personal
disposable income, with the effects of falling employment mitigated by
redundancy payments and by a rise in net property incomes. The rise in
incomes this year should be more modest, at around 3/4 per cent, with
take-home pay limited by the public sector pay constraints and the
decision in the Budget to freeze personal income tax allowances. This
will be offset by further falls in debt TABULAR DATA OMITTED interest
payments, with around 1 1/2 million borrowers on annual review schemes
having only started to benefit in March and April from a 3 percentage
point reduction in mortgage rates.

With consumption forecast to rise by 1 1/2 per cent, the savings
ratio is likely to decline a little this year. Recent figures for retail
sales and car registrations have provided evidence of continuing growth
in consumers' expenditure, although the level of car registrations
declined somewhat in the early months of the year from the peaks
attained after the initial abolition of the car tax. Expenditure will
also continue to benefit from the impact of lower borrowing costs,
although this may be partially offset by any adjustment in future plans
following the announcement in the Budget this year of future tax
increases.

Real net interest incomes are likely to continue to be constrained by
the widening of the spreads between lending and deposit rates by many
financial institutions. The margin between mortgage rates and the base
rate has widened by 1 1/2 percentage points since March last year. The
latest Financial Services Survey by the CBI and Coopers and Lybrand
indicates that average fees, commissions and premiums rose strongly in
the first quarter of the year, and a balance of respondents plan to
widen spreads and raise charges further in the coming months.

Investment and Stockbuilding

The volume of fixed investment has declined sharply since the onset
of the recession, with total investment last year some 13.2 per cent
below that undertaken in 1989. However there are signs that the decline
in investment is coming to an end, with investment by the public sector,
the oil industry and the newly privatised utilities all helping to
ensure some growth in the second half of last year. Manufacturing
investment also began to pick-up after the first quarter of the year,
with investment in the second half of the year some 4.4 per cent above
that in the first.

The rise in the volume of manufacturing investment occurred in spite
of the CBI survey continuing to show a balance of firms planning to
reduce investment. The historical relationship between investment
intentions and actual investment is shown in Chart 7. This suggests that
over time the replies have become a coincident rather TABULAR DATA
OMITTED than a leading indicator of the trends in investment, implying
that the less negative responses in the most recent Survey may be
compatible with further growth in recorded investment. The forecast
shows manufacturing investment rising by 6 per cent this year, helped by
the projected recovery in output and the falls in the real cost of
capital shown in Chart 5. Improved corporate profitability is also
likely to help support expenditure in the coming months, with profits
raised by enhanced labour productivity and a higher sterling value of
foreign earnings.

Public sector investment began to rise strongly in the fourth quarter
of last year, with non-housing investment rising by 10 per cent over the
year as a whole. We expect further increases in public investment this
year, with public non-housing construction orders in the three months to
February some 32 per cent higher than in the previous three months and
some 24 per cent higher than the corresponding period a year ago.
Housing starts are also expected to pick-up over the course of the year
as the housing market continues to stabilize. This generates a rise in
recorded housing investment next year. Overall it is possible that
investment may rise by 4 3/4 per cent next year, with residential
investment rising by 12 1/2 per cent.

Stock levels were reduced by |pounds~0.7 billion in the fourth
quarter of last year, taking destocking over the year as a whole to
|pounds~1.3 billion. This was considerably lower than in 1991, when
destocking amounted to |pounds~3.4 billion. Manufacturers ran down
stocks by |pound~0.5 billion in the fourth quarter, with export sales
being partially met out of existing stockholdings. It is likely that
manufacturers and distributors took advantage of the stronger demand in
the first quarter of this year to reduce stock levels further.

We expect net additions to stocks in the second half of this year,
with stronger demand and production leading to rises in the volume of
stocks of work in progress and raw materials. This may be partially
offset by lower stockbuilding in the rest of industry, with housing
associations purchasing previously unsold new houses and stocks of
energy products having risen strongly over the latter part of last year.
Total stocks of coal at the end of February were 10 per cent higher than
a year ago and TABULAR DATA OMITTED stocks of crude oil were over 3 1/2
per cent higher. As the economic recovery gathers momentum, these stocks
are likely to be run down a little, particularly if oil production this
year remains little changed from its lower level in the first quarter.
Overall, the forecast shows stockbuilding of |pound~0.8 billion this
year and |pounds~2.6 billion next, adding some 0.6 per cent and 0.5 per
cent to GDP respectively.

The decisions in the Budget to limit the increase in business rates
this year and to reform the Advance Corporation Tax system are likely to
improve the liquidity position of the company sector over the coming
year. However there may be some disparity between large companies, who
benefit from the reduction in the ACT rate from 25 per cent to 22 1/2
percent next year and 20 per cent the year after, and that of small
companies, who still face high bank lending rates at a time when working
capital is required to finance any expansion as the economy recovers.

In addition, pressure may be placed on publicly quoted companies by
the simultaneous decision in the Budget to reduce the value of tax
credits attached to dividends from 25 per cent to 20 per cent. The
effect of this change is to reduce the gross income stream for a
non-taxpaying shareholder, such as pension funds, by 6 1/4 per cent,
implying a reduction in the actuarial valuation of many pension schemes.
Ultimately the cost of this downward revaluation is likely to be borne
by the company sector, either through a rise in the cost of equity
finance or through higher contributions to the revalued corporate
pension funds.

The Balance of Payments

The current account deficit deteriorated last year to |pounds~11.9
billion (2 per cent of GDP), some |pounds~5 1/2 billion higher than in
1991. This largely reflected a deterioration in the balance of visible
trade. Income from interest TABULAR DATA OMITTED profits and dividends
rose sharply in the second half of the year due to the higher sterling
value of foreign currency earnings. For many multinational companies the
improvement in foreign earnings following the devaluation of sterling is
more likely to arise through this channel than from higher export
revenues.

Chart 8 compares the trends in the real visible trade balance during
the present recession with those in the previous two UK recessions. In
contrast to past experience the trade balance began to deteriorate in
real terms from the middle of the present recession, although the real
deficit remained smaller than that in the early-1980s recession. The
rise in the trade deficit in 1992 was due to increased import
penetration, reflecting the extent to which domestic producers were
becoming uncompetitive, see Chart 4. The visible trade deficit widened
further in the fourth quarter of last year, with the rise in import
prices following the devaluation adding to the size of the existing
deficit.

As yet we only have non-EC trade data for the early months of this
year. Trade outside the EC accounted for some 44 per cent of exports
last year and some 47 per cent of imports. The first quarter data
suggest a continuation of the trends evident in the fourth quarter of
last year, with the volume of exported goods rising by 4 1/2 per cent
and the volume of manufacturing exports rising by 4 3/4 per cent. There
was also a noticeable rise of 7 1/2 per cent, in the average value of
exports although this may simply be compensating for a lack of price
adjustment in the fourth quarter. Total export prices rose by 2 3/4 per
cent in that quarter, whereas non-EC export prices only rose by 1/2 per
cent. It is likely that prices of exports to EC countries have risen
more slowly, given the weaker state of demand in these economies.

For the year as a whole we expect the visible trade balance to widen
to |pounds~23 billion, with an overall current account deficit of
|pounds~20.6 billion (3 1/4 per cent of GDP). This largely reflects a
continued deterioration in the terms of trade, as export volume growth
is forecast to rise a little faster than import volume growth this year.
A summary of our latest work on exports of manufactures is given in Box
C. Under the assumption that the recession in continental Europe proves
relatively short-lived we expect world trade growth in the main export
markets of the UK to rise by 4 1/4 per cent next year, TABULAR DATA
OMITTED helping to limit the current account deficit to |pounds~19.6
billion.

Sectoral Output

The provisional figures for output growth in the first quarter
contain few clues as to the source of the projected 0.6 per cent rise in
non-oil production. However, the continued rise in retail sales suggests
that distribution output will have risen. Manufacturing output has also
begun to pickup once more, with output rising by 1 1/4 per cent in both
January and February following an improvement in export performance.
These rises are considerably greater than those experienced in the early
part of last year, with output now at a level higher than at any time
since 1990. For 1993 as a whole we expect manufacturing output to rise
by 3 per cent.

Some sectors of the economy still remain in recession, with
construction output proving particularly depressed. Last year output
fell by 5 1/4 per cent. We expect further falls in the early part of
this year before some limited recovery in the second half, helped by the
intended start of work on the Jubilee Line extension and a stabilisation
of the housing market.

The rise in total output in the first quarter was constrained by
renewed maintenance work to oil platforms in the North Sea, with the
value of oil production being reduced by more than the cost of the
safety work. Such programmes are likely to have a smaller impact on
total output later in the year once the base year of the National
Accounts is changed to 1990. The relative size of the oil industry was
considerably smaller in that year than in 1985 due to the weakness of
world oil prices and the Piper Alpha disaster. The rebasing may also
serve to reduce total output both last year and this a little since the
weakest sector of the economy, construction, should have a slightly
greater weight in the rebased index.

TABULAR DATA OMITTED

The Labour Market

The median pay settlement recorded by the Industrial Relations Service in the three months to February was 3 per cent, some 2 per cent
below the level in the corresponding period a year ago. Inflation-plus
deals continue to be the norm, although the average figure for
settlements may fall a little in the coming months as the public sector
pay constraint starts to have its full impact. Total earnings continue
to rise more rapidly than settlements, with the annual growth in whole
economy earnings in the first quarter of the year likely to be around 4
per cent.

It is common to find a wedge between settlements and total earnings,
with bonus payments for factors such as overtime and changes to working
arrangements adding to basic settlements. In addition, changes in the
composition of employment may have an important influence. A number of
commentators have argued that the continued growth of average earnings
over the course of the recession has been, in part, a reflection of the
extent to which job losses have been concentrated on the less skilled
and low paid employees. To the extent that the forecast recovery in
employment results in a number of these workers being rehired, it is
possible that the future overall growth in earnings will be slightly
weaker than we presently show.

We continue to base our forecast for earnings growth on the
assumption that the total public sector pay bill will rise by some 3 per
cent this fiscal year, with annual increments, the delayed feed-through
of some previously agreed pay awards and the increasing reach of
performance bonus schemes ensuring that the pay bill rises by more than
the 1 1/2 per cent basic rate for pay settlements. With private sector
earnings starting to pick-up as the recovery boosts overtime earnings,
we expect whole economy average earnings to rise by a little under 4 1/2
per cent this year. Earning growth should accelerate as the public
sector pay constraint unwinds and the favourable factors that have held
down headline retail price inflation begin to disappear from the annual
inflation rate. In 1994 earnings growth may average around 6 1/2 per
cent, with earnings also boosted by the increasing prevalence of
profit-related pay (such schemes now cover 1 in 20 employees) and the
decision in the Budget to raise employees' National Insurance
contributions.

The level of employment fell by over 600,000 last year with
unemployment rising by 0.4 million during the year. TABULAR DATA OMITTED
The rise in claimant unemployment was smaller than the loss in
employment, with a number of people discouraged from seeking a job and
those with redundancy payments having an enforced wait before they could
claim benefit.

A number of commentators have argued that the fall in claimant
unemployment in February and March of this year was a reflection of the
need of the Employment Service to reach an annual target for job
placements. However the seasonally unadjusted figures for inflows and
outflows of unemployment offer little support for this. The average
monthly outflow in the first quarter of the year, some 365,000, was
little changed from the fourth quarter value. In contrast the average
monthly inflow fell to 366,000 in the first quarter from 402,000. This
suggests that a combination of a decline in the rate of job losses and a
lower participation effect than previously expected are more likely to
account for the observed falls in the claimant count.

The falls in employment were particularly severe in the manufacturing
sector, with employment falling by 5 1/2 per cent last year. With demand
now beginning to show signs of recovering faster than many employers had
previously expected, it is likely that rehiring will take place quicker
than might otherwise have been the case and that redundancies will
diminish. Thus we show employment levels beginning to stabilise from the
middle of this year. In turn this implies that the recent improvements
in productivity growth are likely to slow over the coming months. For
the year as a whole the forecast shows productivity growth of 6 1/4 per
cent in manufacturing and 3 3/4 per cent in the whole economy.

Prices and Costs

With strong productivity growth over the last year of the recession,
growth in unit labour costs has declined rapidly. In the fourth quarter
of last year whole economy unit labour costs were some 2 1/4 per cent
above their level a year earlier, with unit wage costs in manufacturing
actually beginning to decline. With manufacturing wholesale price
inflation remaining unchanged over the course of last year, margins
widened a little. (To the extent that TABULAR DATA OMITTED manufacturers
increasingly rely on brought-in services it is likely that unit costs in
manufacturing alone have become a smaller component of total costs.)

Import prices appear to have reflected the impact of the sterling
devaluation more quickly than many commentators had expected, with the
price of imported goods and services rising by 8 1/2 per cent in the
fourth quarter. Early indications from the first quarter non-EC trade
figures suggest that further rises have occurred this year, with the
average value of imported goods rising by a further 5 per cent in the
first quarter. The higher import prices are increasingly reflected in
producer input prices which, in March, were some 8.3 per cent higher
than a year earlier. For the calendar year we expect input prices to
rise by 8 1/2 per cent, with whole economy unit labour costs rising by
3/4 per cent.

The prices of many consumer services continue to rise more sharply
than goods prices. In the year to March inflation in the household
service, leisure goods and services, travel costs and catering
components of the retail prices index was between 4 1/2 to 5 1/2 per
cent. Together these components account for some 22 per cent of the
overall RPI. Although the total RPI fell sharply in January this year to
1.7 per cent, it has since picked up a little with many of the price
reductions from the winter sales coming to an end. Underlying inflation,
excluding mortgages, stood at 3 1/2 per cent in March, little changed
from its level at the end of last year. The changes in excise duties announced in the Budget are likely to add around 1/2 per cent to prices
both this year and next, although some of the impact this year will be
offset by lower than expected council tax payments. However with import
prices forecast to rise by 10 3/4 per cent over the year as a whole, we
continue to expect that underlying inflation will rise above 4 per cent
in the coming months.

Public Finances

The level of the PSBR rose last year to |pounds~36.5 billion from
|pounds~13.8 billion in 1991/2. This rise reflected the combination of
continued real growth in public expenditure and weak tax receipts.
General government expenditure rose by over 10 per cent in 1992/3 and is
planned to rise by a further 7 3/4 per cent this year. In contrast,
total general government receipts only rose by 3/4 per cent last year,
implying a fall of nearly 3 per cent in real terms, with the Budget
forecast showing a rise in nominal receipts of only 2 1/4 per cent in
1993/4. The rise in borrowing has also resulted in a sharp rise in the
ratio of net public sector financial assets to GDP from 25 per cent in
the first quarter of 1991 to an estimated 34 per cent in the first
quarter of this year.

Total receipts from taxes on income, expenditure and capital,
excluding North Sea taxes, are now a smaller proportion of nominal GDP than at any time since 1978/79. This primarily reflects weak income tax
and corporation tax receipts, with employment and profitability
declining over the recession. The income tax profile has also been
distorted by the extent to which bonus payments were brought forward
into the first quarter of 1992 (fiscal year 1991/2) prior to the general
election. VAT receipts were also weaker than previously expected, with
the proportion of consumers' expenditure going on non-durable goods
and services rising over the course of the recession.

Our projections for tax receipts both this year and next are more
optimistic than those in the Budget. In part, this is due to a
difference in inflation forecasts, with higher inflation in our forecast
raising money GDP. Thus we project the value of nominal GDP in 1993/4
and 1994/5 as |pounds~644 billion and |pounds~696 billion respectively,
compared to the |pounds~628 billion and |pounds~671 billion shown in the
Financial Statement and Budget Report. These higher projections yield
additional revenue of some |pounds~5-6 billion per annum.

TABULAR DATA OMITTED

TABULAR DATA OMITTED

TABULAR DATA OMITTED

TABULAR DATA OMITTED

Box A. The Impact of Changes in Interest Rates

One of the key factors that can be expected to support the level of
activity in the economy in the coming months is the continued emergence
of the private sector response to the cuts in domestic interest rates
that have occurred since last September. The main mechanisms through
which an interest rate reduction affects the economy are via changes in
asset prices such as the exchange rate and the influence of real
interest rates on expenditure, both by companies and by households.
Changes in nominal interest rates can also affect expenditure through
their impact on the cashflow of borrowers and creditors.

In this box we abstract from the exchange rate effect to consider the
direct impact of a reduction in interest rates on domestic demand. Thus
the simulation results shown below should really be taken as an
indication, based on past experience, of the speed with which an
interest rate change affects demand rather than as a precise indication
of the overall impact of such a change. As it makes little economic
sense to assume that interest rates can be permanently held away from
their base levels without any compensating adjustment in asset prices,
it is also the case that the results obtained from the simulation of a
temporary interest rate reduction are sensitive to assumptions about
both the extent and the duration of any change. The figures reported
below resulted from a simulation in which short-term interest rates were
reduced by 2 percentage points for 5 years.

The results in Table A1 indicate that the interest-rate reduction
serves to raise the level of GDP by around 1 3/4 per cent after three
years, with growth in the first three years some 1/2 per cent higher
than otherwise. Investment expenditure rises strongly reflecting both a
lower real cost of capital and higher activity in property markets. The
level of consumers' expenditure is raised by over 2 per cent after
three years, with some limited inflationary pressure beginning to emerge
in the housing market. The GDP response is smaller than the implied
domestic demand response due to adverse movements in net trade, with
higher import volumes and lower export volumes as competitiveness
declines. This eventually leads to a decline in the current account,
offsetting the improvement in the invisibles balance arising from a
lower level of interest payments on banking sector overseas liabilities.

Wage pressures are initially contained by a fall in retail price
inflation, reflecting the impact of lower mortgage rates, although in
the medium term there is a limit to which cuts in interest rates can
restrain inflation in this way. The higher level of nominal activity and
lower unemployment serve to improve the finances of the public sector,
with the ratio of the PSBR to nominal GDP falling by close to 1 per
cent.

Overall, the results indicate that reductions in interest rates can
be a powerful, if somewhat slow-acting, weapon, with output and
inflation still rising strongly in the third year following the initial
change. It is likely that the impact of a 4 percentage point reduction
in interest rates would be stronger still, although this may depend on
the circumstances in which such a change is introduced. At present it is
possible that the high level of outstanding housing debt could serve to
constrain the behaviour of the personal sector whatever the level of
interest rates. However if more normal behaviour is observed, a
relaxation in interest rates is likely to change the composition of
expenditure, by raising consumption and housing demand at the expense of
net exports.

TABULAR DATA OMITTED

Box B. Forecasting with Leading Indicators

In this box we report alternative short-term forecasts for output
growth and consumer price inflation derived from estimated relationships
between these variables and a number of potential leading indicators.
These forecasts, updated every 6 months, were first introduced in the
May 1992 Review. Growth is positively related to past movements in
business optimism, housing starts and real equity prices and negatively
to the yield gap (the differential between short and long-term interest
rates) and past inflation. Inflation itself is predicted using capacity
utilisation, demand growth, input price and exchange rate movements and
changes in long-term interest rates. Additional details are given in
Britton and Pain (1992), with the latest updated equations available on
request.

This time last year, the leading indicator forecasts for 1992
indicated that output would recover quite sharply over the year, with
growth put at 1.8 per cent, whilst consumer price inflation (adjusted to
overcome poll tax distortions) would be a little over 5 per cent. In the
event, whilst inflation was predicted successfully (as it was in our
main forecasts of the time), growth proved much weaker, although output
did start to rise in the second half of the year.

Below we present forecasts for both 1993 and 1994. For the latter,
the required assumptions for interest rates, equity prices, input
prices, housing starts and the exchange rate are taken from our main
forecast. (We have also used an additional technical assumption that the
average level of CBI business optimism in the second half of this year
will be unchanged from that in the first half.) The accompanying charts
show the extent to which the leading indicator models have successfully
anticipated past developments along with their predictions for 1993 and
1994 and those of our main forecast.

The leading indicator forecasts for 1993 are little changed since
last November, with growth projected to be 2.1 per cent, and inflation
to be 4.2 per cent, closely in line with the central forecast itself. As
before, the main impetus to growth comes from the turnaround in the
yield curve since last September, along with the rise in the level of
real equity prices. For 1994, the leading indicator predictions show a
considerably stronger recovery than the main forecast, with growth put
at close to 4 1/2 per cent and inflation rising to a little over 5 1/2
per cent, reflecting the feed through of higher input prices.

Box C. UK Exports of Manufactures

The improvement in the level of export sales that we expect to arise
from the recent change in UK competitiveness is an important factor
behind the recovery we show in GDP growth, both this year and next.
Manufacturing export volumes are forecast to rise by a little over 8 per
cent in 1993 and by a further 6 3/4 per cent in 1994, even though world
trade growth only averages 3 3/4 per cent over these two years. The 13
per cent improvement in UK export competitiveness that occurred in the
last quarter of 1992 should have a noticeable impact on export volumes,
even in a stagnant market, with UK firms able to gain market share.

In our previous econometric work on UK manufacturing exports
(reported in the November 1991 Review) we noted that there had been some
improvement in the UK share of world trade since the middle of the
1980s. The decline over the 1970s and the subsequent turnaround was
'explained' by changes in relative export prices and a
stochastic time trend which, by construction, simply captured any
important omitted factors such as non-price competitiveness or changing
product quality. Our latest research, employing more recent and better
quality world trade data, has resulted in two important changes to our
model. First, we now find a higher competitiveness elasticity than
before, suggesting that any given change in relative prices has a
greater impact on export volumes than we had previously thought.

Second, in contrast to many earlier studies of manufacturing exports,
we now find that it is possible to obtain a coherent equation for
exports with a unit elasticity from world trade without having to use
some form of time trend to capture the fall in trade share in the 1970s.
Movements in price competitiveness alone can now account for this.

The latest data for the UK export share and price competitiveness (a
rise is a fall in competitiveness) are shown in Chart C1. Both series
are scaled so that 1985=100. The chart illustrates the close connection
between market share and earlier movements in competitiveness. It now
appears that UK export performance began to improve a little earlier
than previously thought, with the export share rising slowly from a low
point reached in 1981. As the chart shows, UK exporters appear to have
been increasingly pricing to market in order to gain and retain market
share.

The change in the profile of the UK share of world trade is partly a
reflection of the better quality world trade data that we have recently
constructed. The world trade series itself continues to be a weighted
average of import volumes in the main export markets of the UK. However,
in the majority of cases we have now been able to use genuine volume
data. In our earlier research import volumes often had to be derived by
deflating value data by base-weighted unit value indices. This created a
current-weighted (Paasche) volume index which was used to
'explain' the base-weighted (Laspeyres) index of UK export
volumes. Over time it is to be expected that some trend discrepancy will
emerge between two such alternatively weighted indices. This should not
be the case with our newly constructed world trade index. A similar
point can be made with regard to the relative price series in Chart C1,
which now consists of the ratio of two average value price indices.

The equation which we now use for manufacturing exports was estimated
using the cointegration methodology, with the residuals from a
'first-stage' cointegrating regression being included in a
subsequent dynamic equation for exports. The preferred specification is
shown below. Here X, W and P/P* denote export volume, world trade and
the price of UK exports relative to weighted world export prices. The
competitiveness elasticity is now estimated to be -0.5, compared to -0.3
in our previous research.

The forecast draws on the work of the whole team engaged in
macroeconomic analysis at the Institute. I am grateful to Andrew
Britton, Ray Barrell, David Wilkinson and Garry Young for helpful
comments and discussions and to Helen Finnegan and Gillian Francis for
statistical assistance. The forecast was completed on 7 May 1993.

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